The influence of the accruals generating process on earnings persistence

Abstract

In this paper we categorise accruals on the basis of how they are generated, and empirically evaluate whether this categorisation provides additional insights into future earnings and is relevant to the estimation of firm value. Specifically, we categorise accruals on the basis of whether the underlying cash flows lead or lag earnings recognition, and whether the accruals are initiating or reversing (i.e. a four-way categorisation). We demonstrate that these accrual categories are not homogeneous, have differing implications for earnings persistence and are relevant for firm valuation. Significantly, where cash flows lag earnings recognition (e.g. sales made on credit) they have greater implications for future earnings than where cash flows lead earnings (e.g. unearned revenues) and depreciation. Similarly, initiating accruals have greater implications for the persistence of earnings than reversing accruals. Paradoxically, while depreciation exhibits high persistence, it has less of an implication for the persistence of earnings than either lag or initiating earnings categories. These findings enhance our understanding of the properties of accounting income and how it is impounded into share prices.